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– Data on all shareholder equity and classes of stock used by the company,
including the type of stock, number of shares authorized and outstand-
ing, any voting rights, dividends, warrants and options outstanding, the
owners™ names, prices offered, and any special terms. Determine
whether any of the following items are also included: stock option plans,
restrictions on stock, preemptive rights, rights of first refusal, convert-
ible instruments, and agreements for further issuance of stock.
264 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


An income statement is a record of the revenues and expenses for a given
accounting period. An accounting period is usually one year. The forecasted
income statement matches amounts the company expects to receive from
selling goods and services and other income against cost and outlays incurred
to operate the company. The income statement is also called a profit-and-loss
statement or”when there is a loss for the period”a statement of operations.
The accuracy of a pro forma income statement is directly related to the as-
sumptions used in creating the sales plan.


Questions for the Income Statement
Sales

– How are sales or revenues or losses recognized?
– Are sales front loaded; that is, recognized before being collected in full?
– To what extent are future revenues dependent on R&D projects in
process?
– At what rate are revenues projected to increase annually for the next
three years? How does this compare with industry estimates?
– Are forecasts based on historical results, trends, or any industry analysis?
– How were projections developed? Should they be discounted? Have pro-
jections been achieved in the past?
– What method was used to forecast growth: trend projections, market
studies, management™s best guess?

Costs
– How does the company recognize costs of production? Recognize
overhead? For example, is it using standard costs that it corrects for
rework?
– How are costs budgeted, monitored, and controlled?
– What are the critical costs to keep under control?

Earnings
– Is management contemplating any potential future earnings adjust-
ments, such as salary adjustments, different tax provisions, and so on?
– Has management provided realistic best-case and worst-case circum-
stances for projecting earnings?
– When potential increases in costs are incorporated into the projections,
is gross profit percentage maintained in the projections?

For both new and existing businesses, the cash flow forecast is the most
265
Preparing for Due Diligence


important projection because it details the amount and timing of expected
cash inflow and outflows; that is, it incorporates sources of cash and uses of
cash in any given time frame to determine the cash outlay and the net cash
available. In effect, the statement of cash flows examines changes in cash re-
sulting from all business activities. Generally, the cash flow in the start-up
years of a business will not sufficiently finance the operational needs. Cash
inflows often do not match the outflows on a short-term basis. The cash flow
forecast will indicate these conditions and enable the investor to evaluate
management™s plan for cash needs.
Given a level of projected sales and capital expenditures over a specific
period, the cash flow forecast will highlight the need for additional financing
and indicate peak requirements for working capital.


Questions for the Cash Flow Statement
– How many depository accounts are there? What are the balances in
those accounts? How much cash does the company have?
– How much cash flow does the company handle monthly?
– Does the company have multiple collection points?
– How many disbursement accounts does the company have? Who au-
thorizes payments? Who is in control of disbursements?
– At what point in time will cash flows become positive?
– What is the monthly cash burn rate, and how will this forecast fluctuate
pre- and postfinancing?
– At what rate are earnings projected to increase over the next three to five
years?
– Is the company taking advantage of discounts for early payment when
available?
– Is the company maintaining the minimum cash balance required in its
operating accounts?

Why does the company need capital now? How will the company use
the funds currently being raised? These questions are answered in the
use-of-proceeds statement. Normally, the uses of proceeds cover such capital
expenditures as purchase of property, leasehold improvements, purchase of
equipment and furniture, and other types of capital expenditures. In addi-
tion, in a use-of-proceeds listing, working capital commonly will be required
for such activities as purchase of inventory, staff expansion, new product line
introduction, additional marketing activities, and other business expansion
activities. In some instances, debt retirement or establishment of cash re-
serves will be the focus of the use-of-proceeds section.
266 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


Questions for the Use of Proceeds
– If the company has raised money in the past, how did it use past funds?
– Why does the company need money now? Specifically, how will it use
the money? Spell out each item that the company plans to spend money
on.
– Are there any broker fees that portions of the proceeds will go to pay?

Investors will most likely ask for a list of assumptions used by manage-
ment in preparing all pro forma financial statements. How were assumptions
developed? Are the details believable?


Questions on Financial Assumptions
– What are the chances of the company™s achieving projections?
– What major problems did you identify in the projections, and what are
management™s plans to overcome them?
– Can the problems be realistically solved within your time frame to
achieve returns?
– If the company fails to achieve financial objectives and must be liqui-
dated, what is your downside recoverability?
– Based on further financial requirements for the company that have been
identified, are you prepared to reinvest in the future?

In addition to financial statements, entrepreneurs can expect requests for
lists of investors, advisers, directors, and other resources for reference
checks. A list based on our experience of requested references and other ma-
terials is provided below. In addition, miscellaneous documents investors
might request include a capitalization table disclosing pre- and postfinancing
ownership, organization chart, resumes of key management with references,
certificate of incorporation, business licenses, list of officers and directors,
employment contracts, noncompete agreements, list of suppliers, and leases.
If an operating company, investors may ask to see tax returns for all years
filed, materials of any past or present lawsuits, insurance policies for key per-
sonnel, patents, trademarks, copyrights, details on outstanding stock, R&D
reports, incentive plans, any SEC filings, list of depository accounts, and
credit reports.


LISTS FOR REFERENCE CHECKS
Be prepared to supply names and contact information for the following:
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Preparing for Due Diligence


– Institutional investors and lenders
– Any investment banking firm involved in the transaction
– Law firm and corporate legal counsel
– Names of the accounting firm(s) for the past three years
– Bank(s), banker, and any private credit source
– Board of directors, officers, and advisory board
– Broker dealers or underwriters involved in the transaction
– Private and corporate investors and any other stockholders in the com-
pany
– Finders or financial intermediaries assisting the company
– Consultants, past and present, who advised or analyzed the company
– Appraisers involved in valuation of the company
– Key customers
– Landlord
– Public relations, marketing, promotion, or advertising firm retained by
the company
– Institutional industry analyst following the industry and venture capital
firms investing in this industry
– Key competitors
– Top three publicly traded companies in the industry.
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Valuation of the Early-Stage Company




13
CHAPTER

Valuation of the
Early-Stage Company

INTRODUCTION
If any term receives reverential treatment in the business of financing a ven-
ture, it is surely valuation. And such distinction is well earned. Valuation
haunts every aspect of a venture; in its very scope, valuation becomes the en-
tire process writ small. No deal gets very far without it; no deal can be tor-
pedoed more quickly if it is off the mark. The best test of a deal™s
practicability and pricing is whether it can attract, and be sold to, another
private investor at the same price”in other words, its valuation. However,
investors typically will rely on their own judgment in evaluating a deal.
John Cadle, a valuation expert, has sage advice about valuing a venture.
To begin with, explains Cadle, unlike buying an existing business with lots
of assets”an event possessing formulated definitions of what value is”for
the early-stage company, no recognized definition of valuation exists. Cadle
warns entrepreneurs to realize that in an early-stage venture, the value is in
the future. Therefore, definitions are limited. Determining value in early-
stage investing is highly subjective, because such determination depends on
something that has not yet happened.
So our bias is that valuation is more art than science, a tricky business
based on judgment and assumption. Valuation at best is imprecise, an esti-
mate or extrapolation with no hard-and-fast rules for the entrepreneur to
follow. Methods of calculating value are customized, not standardized. Once
the investor decides his or her interest in investing, valuation begins.
Thus, into the valuation mix go many subjective elements: the expe-
rience and cohesion of the management team; the size and growth rate of the
market; whether the business is in manufacturing, service, or retail; whether
the product or service has a competitive edge; whether the venture is a prod-
uct or business; the degree of market development (missionary selling) re-
quired; the likelihood of additional financing, planned or not; whether the
exit strategy is realistic; whether the deal has been overshopped; and how
persuasive and committed the founders and management team are.

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270 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


With so subjective a mix, valuation is best deferred until later on in the
process, after you have that investor believing firmly in you as an entrepre-
neur, after he or she is sold on the dream. It is a big mistake, cautions Cadle,
to bring up valuation too early; better that valuation be considered later on
in the relationship.


PRICING AS GOOD JUDGMENT, NOT FORMULAE

One element that characterizes all early-stage ventures is their illiquidity. As
we mentioned, one test of a deal™s practicality and pricing is whether it can
attract and be sold to another private investor at the same price, although
not necessarily the highest price”in other words, sold at the same val-
uation to another investor. In addition, investors could do worse than
to seek opinions from their network of co-investors to obtain the bids of
other respected, experienced investors. Estimates from others that reason-
ably approximate an investor™s own appraisal can increase confidence in
valuation assessment. Ironically, the value of an illiquid company may be as
much a function of finding an investor as that of financial formulae and
calculations.
To repeat, investors rely on their own judgment in valuing a deal, a judg-
ment mandating considerable investigation and analysis. Some factors have
an obvious effect on value (i.e., low risk means higher value); computing
value is a complex affair fraught with problems. Valuation is not a precise
form of financial analysis; it is more akin to an art form or, at times, even
horse trading. In valuation, subjective factors we mentioned can simply
eclipse objective factors. The mass of intangibles is often overwhelming and
weighs heavily on investors, causing two sophisticated investors to reach two
different estimates of value. For example, to the extent that investors are fa-
miliar with the business, they might give the entrepreneur a higher valuation
because they perceive their risk as being lower, whereas the investor who is
investing in a business about which he or she knows nothing will not. Since
value is in the future, definitions are limited. Limited too are calculations in-
fluenced by incomplete information, rapidly changing environmental fac-
tors, unproven management, untested technology, and undeveloped markets.
Determining value in early-stage investing is highly subjective because so
much depends on something that has not yet happened. In addition, the ne-
gotiation skills of the investors and entrepreneurs themselves can become
variables influencing the valuation outcome.
In the wake of stock market fluctuations, the spotlight now falls more
than ever on the vagaries of valuation. In 1999 to 2000, public market com-
panies with little-established earnings had been trading at 1,200 times earn-
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Valuation of the Early-Stage Company


ings, and 5 percent of the entire stock market contributed 70 percent of the
wealth by the end of 2000. It seemed that even public equity players threw
caution to the wind. Public enthusiasm pushed valuations very high by his-
toric standards, especially since a number of start-ups had been more suc-
cessful than anticipated.
The astounding multiples at which many Internet start-ups with no earn-
ings or immediate potential for earnings had been valued at the time has
served only to reemphasize the use of traditional valuation models to esti-
mate early-stage technology company value. Investors are relying on com-
mon sense for guidance, using comparative analysis of similar firms to
ascertain proper funding levels, valuation, and equity share. If the venture
fails, any valuation is irrelevant. In private investing, survival is everything.
As we have reiterated, smart investors are risk averse, regardless of what en-
trepreneurs believe! The foremost thing they want to know is not what their

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